"Hubris itself will not let you be an artist" Larry Wall
There are often fixed criteria when it comes to looking for a mutual fund: the cost or fees the fund charges, the long-term track record of the fund and lastly, the tenure of the mutual fund manager. One of these may not matter.
While the cost of the funds you invest in play an incredibly important role in the performance of your mutual fund investments, it should stand alone as the basis of choice. Fees in a mutual fund have a direct impact on any return you are likely to garner.
Of course, this would eliminate the vast majority of choices. The lowest cost mutual funds are indexed and remain the one argument as to why your portfolio should be stuffed with this practical investment option. Index funds, as the name suggest, simply track a published index and can do so with little effort from the fund family. This hands-off approach (unless the underlying index rebalances) keeps all costs passed on to the mutual fund shareholder at the lowest possible price.
The long-term track record of a mutual fund and the manager that is at the helm however should be harnessed together. A good fund manager can keep the costs of his/her fund down with only one approach: less trading. But less trading comes dangerously close to mimicking an index fund. So they trade.
Actively managed mutual funds dominate the mutual fund universe, perhaps not in total dollars invested, but in choice, with over 70% of the funds falling into this category. By suggesting that this fund manager can control costs relies on investment success. This creates a track record which in turn attracts new investors (brokers are at the forefront of touting the best performers in the short-term). And lack of redemptions, what exiting investors create, keep the need for portfolio rebalancing at a minimum.
But a market hiccup can unravel what may turn out to be the most common trait of any successful person: hubris. Once you have success, and mutual fund managers are no different when it comes to this, you believe what you say. You walk the path you have constructed, often blind to what might have been the writing on the wall.
This can be forgiven everywhere but in your mutual fund investment. Aside from answering the call of the index fund, three things need to be considered.
If you are looking at an actively managed mutual fund it is because the fund has had some recent success. Looking over the long-term and determining whether it was the current manager who achieved those successes is important. An exiting fund manager will have had his/her reasons for leaving and when the helm of the fund is restructured, it is often with an eye on throwing out the old and bringing in the new.
A new fund manager is likely to sell profitable holdings (and not-so profitable ones as well) and this may increase the returns in the short-term. The stocks they buy may be the most recent winners and this will give the returns a boost as well. And then there is luck. As I write this (late 2011), the markets are not exactly predictable. So being in the right place at the right time is more than simply skill.
All of that trading and shifting costs money is weighing performance against this consideration is key to pulling out the real return.
But what of the manager who has been around for awhile? Bill Miller, the fund manager at Legg Mason Value Trust (LMVTX) recently announced he would step down. He was, by all standards, a mutual fund all-star with fifteen stellar performance years to prove it. But his fund, like so many others didn't see 2008 coming and suffered the wrath of that downturn much harder than the S&P 500 index did even with dividends reinvested.
And when the market recovered significantly (but not fully) the following year, Mr. Miller's fund did not. Add to that, his expenses (1.77%) were higher than the average blended fund (a type of fund that looks for large growth companies that have been misplaced by the markets). This continued to impact his reruns putting him at the bottom of his category. Only hubris would keep a fund manager in a deteriorating position long after it has run its course.
Should Mr. Miller signal a better look at the long-term fund manager? Perhaps and with good reason. Unless the fund manager has been given a increasingly better compensated role in the fund family, he probably would have left for the hedge fund world long ago. That cost of expertise is paid for by you and sold in kind as the reason to buy. Longer than five years may not be the best indication of a funds ability or the fund manager's skill level.
So we have tenure (not an issue in an actively managed fund it seems), hubris (the net effect of successes and the inability to see what is coming) and lastly size. Too big is too hard on any fund manager. It means that your reputation and your performance in the short-term has supplied you with a steady stream if cash from new and existing investors.
This can become a cumbersome chore and if the fund is focused on a narrow marketplace. With investments such as small-cap funds or even some mid-cap funds, the difficulties of putting that inflow of money to work without impacting the the net price of whatever it is they are buying is difficult. Only in index funds and ETFs (which 90% of the available options are indexed) are not impacted by investor enthusiasm - with one exception, when the markets go up.
Actively managed mutual funds may believe that the fund manager is important and that their tenure is as well. But unless they can be successful and control the costs, they only detract from where the fund will be in the future in more instances than not.